Posts tagged ‘The Alchemy of Finance’
Billionaire investor George Soros, who is also Chairman of Soros Fund Management and author of The Crash of 2008¸ is well known for his theory on reflexivity, which broadly covers political, social, financial, and economic systems. Soros built upon this concept (see also Soros Super Bubble), which was influenced by philosopher Karl Popper. With all the fear and greed rippling through global geographies as diverse as Iceland, California, Dubai, and Greece, now is an ideal time to visit Soros’s famous reflexivity theory, which may allow us to put the recent chaos in context. With the recent swoon in the market, despite domestic indicators trending positively, a fair question to ask is whether the dog is wagging the tail or the tail wagging the dog?
The Definition of Reflexivity
Simply stated, reflexivity can be explained as the circular relationship that exists between cause and effect. Modern financial theory teaches you these lessons: 1) Financial markets are efficient; 2) Information flows freely; 3) Investors make rational decisions; and 4) Markets eventually migrate towards equilibrium. Reflexivity challenges these premises with the claims that people make irrational and biased decisions with incomplete information, while the markets trend toward disequilibrium, evidenced by repeated boom and bust cycles.
Let’s use the housing market as an example of reflexivity. By looking at the housing bubble in the U.S., we can shed some light on the theory of reflexivity. Americans initial buying love affair with homes pushed prices of houses up, which led to higher valuations of loans on the books of banks, which allowed the banks to lend more money to buyers, which meant more home buying and pushed prices up even higher. To make matters worse, even the government joined the game by adding incentives for people who could not afford homes. As you can see, the actions and decisions of an observer can have a direct impact on other observers and the system itself, thereby creating a spiraling upward (or downward) effect.
Now, the reflexivity tail that is wagging the dog is Europe…specifically Greece. The bear case goes as follows: the Greek financial crisis will brew into a stinky contagion, eventually spreading to Spain and Italy, thus hammering shut a U.S. export market. The double dip recession in the U.S. will not only exacerbate the pricking of the Chinese real estate bubble, but also topple all other global economies into ruin.
Certainly, the excessive sovereign debt levels across the globe have grown like cancer. Fortunately, we have identified the problem and politicians are being forced by voters to address the fiscal problems. More importantly, capital flows are an unbiased arbiter of economic policies. Over time – not in the short-run necessarily – capital will move to where it is treated best. Meaning those countries that harness responsible debt loads, institute pro-business growth policies, remove unsustainable and insolvent entitlements, and incentivize education and innovation will be the countries that earn the honor of holding their fair share of vital capital. If the politicians don’t make the correct decisions, the hemorrhaging of capital to foreigners and the painfully high unemployment levels will force Washington into making the tough but right decisions (usually in the middle of a crisis).
Reflexivity, as it pertains to financial markets, has been a concept the 79 year old George Soros has passionately espoused since his 1987 book, The Alchemy of Finance. Perhaps a better understanding of reflexivity will help us better take advantage of the tail wagging disequilibriums experienced in the current financial markets. Time will tell how long this disequilibrium will last.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
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